We mentioned yesterday that a lot of traders got caught in the flood when the easy yen trade reversed course in the wake of the Italian elections. This was a bet predicated on two promises from officialdom: Mario Draghi’s promise to do “whatever it takes” to safeguard the euro, and Shinzo Abe’s promise to debase the yen. Ipso facto, sell the yen and yen-denominated assets, buy the euro and euro-denominated assets.

But it all went haywire in the aftermath of Italy’s parliamentary elections, when a former prime minister and a comedian took more than half the vote. It was a stunning rebuke to the established order, and at this point nobody knows exactly what the ramifications will be.

You don’t need the “fear gauge” to tell you stocks are getting volatile.

The Dow finished up 116 points Tuesday, a 0.8% gain, closing at 13900, after dropping 216 points yesterday. That was good enough for the index’s fourth-biggest gain this year.

But the index also had two days last week where it swung by 100 or more points, Friday and Wednesday. That’s four of the past five sessions.

In fact, after the equities market roared out of the gate with that strong January, they’ve been erratic in February, and with just two sessions left in the month, the Dow is up just 39 points on the month.

We’ve learned a couple of things this week, and it’s only Tuesday. We’ve learned, courtesy of the beautifully messy Italian political process, that Europe’s problems indeed have not been solved, and we’ve learned today that Ben Bernanke is a through-and-through dove.

The Fed Chairman trotted up to Capitol Hill this morning and put to bed all this talk about the Fed changing direction, cutting short its massive stimulus efforts. “We do not see the potential costs of the increased risk-taking in some financial markets as outweighing the benefits of promoting a stronger economic recovery and more-rapid job creation,” Bernanke said in his prepared remarks, maintaining his standard line. The only surprise is that anybody even worried that Bernanke might change his tune.

The markets may find themselves in need of such unwavering support. A global trade emerged – buy risk (i.e., the euro), sell safety (i.e., the yen) – predicated on the idea that the Fed and the ECB, and whoever runs the Bank of Japan for that matter, can and will manage any crises that erupt. We called it the Universal Put. Yesterday’s brutal reversal in the yen trade and sell-off in U.S. equities was a fresh lesson in how swift, global, and interconnected the markets have become. Many were caught off guard.

Italy's political stalemate has sent government bond yields spiking, in an episode reminiscent of what regularly transpired during the height of Europe's debt crisis the last few years.

Yields on 10-year Italian bonds jumped as high as 4.917% on Tuesday, according to Tradeweb, the highest level since November. Spanish, Portugal and Greek yields were also higher as a classic flight-from-risk pattern emerged.

Italian stocks have also swung wildly over the last two days. Mario Monti didn't perform as well as previously anticipated, while Silvio Berlusconi performed better than expected, creating the specter of a hung parliament and the potential for another election in a few months.

U.S. stocks are chasing the euro lower, as markets around the globe fret over the possibility of a hung parliament in Italian elections.

The picture forming in Italy is not filling investors with confidence that a new government will remain on the austerity track, which could then lead to widening sovereign debt yields and another flare-up of the euro-zone debt saga. A hung parliament could set the stage for another election in a few months

The euro fell below $1.31 for the first time in a month, as Silvio Berlusconi’s better-than-expected showing in early polls has been viewed as a wake-up call. Despite improving credit conditions in the euro zone, popular opposition to austerity programs will pose a significant challenge to the region’s growth in the coming months, says Brian Daingerfield of RBS.

An exit poll now has Silvio Berlusconi’s coalition leading 31-29.5% over Pier Luigi Bersani in the Senate, contrasting initial exit polling. Earlier polls had indicated the country’s center-left coalition government, led by Bersani, had a commanding lead, which was seen as the most market-friendly outcome.

Treasurys have reversed earlier weakness and Italian bonds pared their rally. The 10-year Treasury note is now 3/32 higher in price, yielding 1.957%, after earlier getting as high as 2.002%. The euro recently turned negative at $1.3204, earlier hitting a session high of $1.3319.

The development knocked risk assets, including U.S. stocks, from earlier highs as well, and in general, traders says they are bracing for more short-term price swings.

The decision came after former Prime Minister Silvio Berlusconi’s party withdrew its support for Monti’s technocratic government. Berlusconi has also indicated he wanted to return to politics.

As we’ve reported this morning, increased political uncertainty sent the yield on 10-year Italian bonds to 4.816%, up from 4.53% at Friday’s close, according to TradeWeb. Yields are now at the highest level since Nov. 21. Italian stocks also fell.

“If there is one certainty in Italian politics, it’s uncertainty,” says Peter Boockvar, managing director at Miller Tabak & Co. in New York. “As the US has had just 12 presidents since WWII, Italy has had 26 different PMs. The difference now though of course is the fragile state of the country’s finances where consistent policy is most desired.”

Despite the latest move higher, Italian bond yields are well below levels hit over the summer. And as the chart below shows, at the beginning of the year yields were above 7%, widely considered an unsustainable level.

Italian bond yields shot up sharply this morning after weekend news that Prime Minister Mario Monti would resign earlier than expected. The catalyst for Mr. Monti’s exit is the loss of support from Silvio Berlusconi’s party.

Mid-morning in London, Italian 10-year yields were at 4.80%, up from 4.53% at Friday’s close. The Italian two-year shot up from 1.96% Friday to trade around 2.28% Monday. Rising yields mean falling prices. Which we’re also seeing on the Italian stock market: The FTSE MIB is down 3.4% this morning.

Bill Gross put money where his mouth is, warming up to Spain and Italy while pulling back from the U.S.

Gross, manager of the world’s biggest bond fund at Pacific Investment Management Co., cut holdings of Treasury bonds in September for a third month, bolstered by his worries that the U.S. fiscal woes and highly accommodative monetary policy would erode investors’ confidence in the world’s go-to safe haven asset.

At the same time, he boosted non-dollar bonds sold by developed nations. The move confirmed his comments in an interview Friday with Dow Jones Newswires that he has bought Spanish and Italian government bonds in recent weeks after staying out of the debt market from troubled euro zone economies since the start of the year.

After fretting about the euro zone’s debt crisis for months, Bill Gross, manager of the world’s biggest bond fund, is going through a change of heart toward the region’s sovereign debt.

Mr. Gross, founder and co-chief investment officer at Pacific Investment Management Co., says he recently has bought government bonds sold by Spain and Italy. The catalyst: the European Central Bank’s bond-buying program unveiled in early September, which he believes could allow policymakers in these troubled economies a short period of breathing room within which to address their fiscal woes.

“Spain and Italy are recent adds based on expectation that the ECB will buy them in a few weeks,” Mr. Gross told Dow Jones Newswires in emailed comments Friday. He explained his philosophy in such situations as: “Buy what central banks buy before they buy them.”

Total return on Irish, Italian and Spanish bonds have done well in recent weeks, though Spain is lagging for the year.

By Matt Phillips and Matt Wirz

The premium investors demand for lending to troubled countries like Spain and Italy has dropped sharply in recent weeks, and there may be more room for them to fall after today’s ruling from the German Constitutional Court.

But they’ve got a long way to go before anybody considers these safe bets again.

In total return terms — meaning including price gains and interest payments — Italian government bonds have been big winners this year.

Through Tuesday, they were up 14.6%, year-to-date. Much of those gains have come over the last couple months.

Since the day before Mario Draghi’s July 26 pledge to do “whatever it takes” to preserve the currency union, Italian Treasurys are up 9.7%, according to Barclays index data.

The total return on Spanish bonds have done even better since Draghi’s comments, rising 10.7%, although year-to-date they’re up just 1%.

The August relief rally of European credit seems to be coming to an end as turmoil threatens to flare up around Greece yet again. The cost of credit default swaps on Italian and Spanish government and corporate debt surged last week as rhetoric between Greece and Germany grew more heated.

The cost of insuring $10 million of Italian five-year government bonds has risen 11% over the past four trading days to $440,000, while the price of protection on Spain is up 8% over the same time period, according to Markit. The price of swaps on Telecom Italia SpA bonds rose 14% last week, while protection on Spain’s Telefonica SA jumped 15%.

Bond prices also dipped last week but not to the same extent as more liquid credit default swaps. The yield of Spain’s five-year bonds rose 5% over the past five trading sessions, while Italian bond yields rose 3% last week, according to FactSet.

Spreads on Italian and Spanish CDSs began dropping in late July after European Central Bank President Mario Draghi pledged to do “whatever it takes to preserve the euro,” a comment some interpreted as a precursor to more government bond purchases by the bank. In subsequent weeks, the cost of protection on five-year Italian and Spanish sovereign bonds declined by about 30%.

Alright, hot-stock boys. We’ll give you a full minute or two, if you chose to take it, to feel unmitigated joy at the thought that the Europeans finally “get it,” and are moving decisively to stanch the bleeding and finally put a stake through the heart of their never-ending crisis.

Go ahead. We’ll wait.

Finished? Good. Because this is like watching one of those horror-movie franchises, Scream, Saw, Friday the 13th, where the plot’s always essentially the same, the only difference is a couple of actors and maybe somebody different’s hiding behind the Ghostface mask. You know he’s hiding in the closet. You know he’s not really dead. You know there’s yet another sequel coming. Call this one Summit XX: Still Kicking.

We see this market rallying, and we just want to scream: turn around! He’s right behind you!

Markets are surging across the board on news of the latest European agreement, which is in essence once again a Plan to Have a Plan. We’ve been through this exercise too many times to count. Yes, there was a deal: Europe’s banks will be allowed to tap bailout funds directly, assuming a European-level regulator is put in place (by January, no less) and government loans won’t subordinate private creditors. But when you really break it down, as our Charles Forelle does here, you’ll find that the Europeans didn’t really agree to much of anything new.

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